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intended to be informational only. We caution you against using or
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article, shall be governed by Alberta law and shall be within the
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Amendments
on May 17, 2005
to the Alberta Business Corporations Act (“ABCA”) make Alberta
more attractive to foreign investors and business. Of interest to some
investors will be changes to the treatment of capital stock, to financial
disclosure and reporting rules, and to the residency requirements for
directors, which are discussed further in a forthcoming article, but still others
long awaited Alberta’s response to the Nova Scotia Unlimited Liability Company
(“NULC”).
Until 2005 Nova
Scotia was the only Canadian jurisdiction offering
Unlimited Liability Companies (“ULCs”) for tax
planning purposes, although most Canadian jurisdictions had similar legislation
at one time. This was serendipitous. The NSULC is a hundred year old artifact found in the Nova
Scotia Companies Act (“NSCA”), originating with the U.K. Companies Act, that was seldom noticed
and rarely used until the early 1990s. U.S.
tax planners gave new life to the ULC following the introduction of the Internal
Revenue Code “check-the-box” regulations in 1997.
The ULC creates somewhat of an
anomaly in tax law. Under both Canadian and U.S.
tax law a partnership and a branch are flow-through vehicles, so any income
derived from either is taxed in the partners’ or owners’ hands. On the other
hand, a corporation is taxed as a separate taxpayer. This is consistent with
international commercial practice. However, for tax planning purposes the
“check-the-box” regulations changed everything.
In Canada
the ULC is treated as any other corporation for Canadian tax purposes. Under
the “check-the-box” regulations the ULC may be treated as a disregarded entity,
either a branch or a partnership, and not a corporation, for U.S.
tax purposes. As a result of the hybrid tax treatment of the ULC any corporate
income, expenses and losses will flow-through directly to the shareholders as
income, expenses and losses. Furthermore, withholding tax may be reduced or
avoided.
The benefits of the ULC structure
specifically relate to U.S.
cross-border transactions, which are discussed in further detail below.
What is It?
By
definition what differentiates a ULC from a typical corporation is that the
shareholders have unlimited liability. The ULC mixes some of the characteristics
of a corporation with those of a partnership. In theory the shareholders of a
ULC are not true partners so they cannot be sued by creditors of the ULC
directly in their capacity as shareholders, but upon winding up or liquidation
each shareholder is liable, jointly and severally, for all the debts and
liabilities of the ULC.
The liability of an ABULC
shareholder may be more onerous. As a result of the wording of the ABCA the
liability of an ABULC shareholder is broader than that of his Nova
Scotia counterpart and potentially may, without
amendment or guidance from the courts, continue for
the lifetime of the ABULC. The shareholders of the NSULC have no direct
liability to the ULCs creditors. A NSULC
shareholder’s liability for debts and liabilities “kicks in” only if the
company cannot meet its obligations upon winding-up or liquidation and only to
the extent of any deficiency. The ABULC shareholder’s liability is expressly
“unlimited in extent and joint and several in nature” by the articles of
incorporation. There is a risk that the ABULC and its shareholders may be sued
contemporaneously by a creditor, even if the ULC has sufficient assets to
satisfy the claim. This is, however, an unlikely result as the ABULC is a body
corporate with a separate personality from its shareholders so the liability of
the ABULC shareholder must be something less than that of a true partner in
partnership.
Further, a
past shareholder of an ABULC is liable for the ULC’s
debts and liabilities for up to two years prior to dissolution. The NSCA does
not impose liability on a former shareholder if it ceased to be a shareholder
more than one year before the wind-up or liquidation or for debts and
liabilities incurred after it ceased to be a shareholder, and only where the
court determines that the current shareholders cannot satisfy the deficiency.
How Do I Get One?
You can set
up an ABULC in the same manner as an ordinary limited liability corporation. To
create an ABULC the ABCA requires only that the articles of incorporation
expressly state that the liability of each shareholder is unlimited and joint
and several. An ABULC may also be created by amending the articles of
incorporation. A non-resident corporation may also be continued and converted
into an ABULC.
How Do I Keep One?
The ULC,
whether formed in Alberta or Nova
Scotia, should be a low maintenance tool. For
non-residents this means a registered office in Alberta
and annual returns, as well as the usual directors’ and shareholders’
resolutions. Annual financial statements may be waived.
What Do I Do With It After I’m Done With It?
Once the
ULC is no longer required the ULC may be converted into a limited liability
entity. In Alberta this can be
done merely by amending the constating documents. In
that case the shareholders’ unlimited liability continues for any action, claim
or liability that existed before its conversion.
What Should I Consider When Setting One Up?
To blunt
the sharp edge associated with a ULC’s unlimited
liability it is absolutely essential that a limited liability entity is imposed
between the ULC and the U.S. taxpayer, which can be done by use of a
corporation (an S Corporation or a C Corporation), or a limited partnership. An
S Corporation is a corporation that has elected to be treated as a flow-through
entity for U.S.
tax purposes. A C Corporation is any corporation that is not an S Corporation.
The use of an S Corporation as a
flow-through entity is preferred over a Limited Liability Corporation (“LLC”). Canada
does not extend treaty benefits to LLCs as they are
not liable for U.S.
taxes. However, the CRA does recognize S
Corporations as U.S.
residents for tax purposes.
As
mentioned above the “check-the-box” regulations make it possible for a ULC to
be considered a branch or partnership for U.S.
tax purposes. Prior to the “check-the-box” regulations the IRS
characterized a foreign entity as a corporation for U.S. tax purposes if it
displayed three of the following four criteria: (1) continuity of life; (2)
centralization of management; (3) free transferability of interest; and (4)
limited liability. Some U.S.
states still use these criteria for state tax purposes, so it is important that
the articles of incorporation of the ABULC also restrict the transfer of
shares, decentralize management or limit the life of the company.
For obvious
reasons a ULC should not issue shares or stock options to its employees.
Furthermore, a lender should be careful when taking a pledge of shares as
security for a loan. Enforcing the loan could result in the lender being deemed
a shareholder, which could make the lender liable for all the debts of the ULC.
Things You Can Do With a ULC
Canadian Corporate Presence
and Branch Tax
One
advantage of the ULC is to allow a U.S.
taxpayer to have a Canadian corporate presence for marketing and tax purposes
while at the same time keeping the ULC as strictly a branch operation of the U.S.
taxpayer for U.S.
tax purposes. Typically, a U.S.
business operating a permanent establishment in Canada
is subject to Canadian tax. A U.S.
corporation operating in Canada
is also subject to a branch tax under Part XIV of the Income Tax Act. The ULC operates in Canada
as if it were a branch of the U.S.
taxpayer, so the branch tax of 25% is reduced to 5% by the Canada-U.S. Tax Convention. Furthermore, under the Canada-U.S. Tax Convention the taxes on dividends are subject to only a 5%
withholding tax instead of 15%.
U.S. Foreign Tax Credit
Subject to
the foreign loss recapture rules, a U.S.
individual taxpayer may be entitled to a foreign tax credit on any Canadian tax
paid by a ULC. A foreign tax credit could be used to offset any U.S.
tax liability on that U.S.
individual taxpayer’s profits from all sources.
However, if the U.S.
taxpayer is a corporation the gains are more modest. Normally, a corporation is
already entitled to a foreign tax credit for any Canadian tax paid by its
Canadian subsidiary corporation in the year in which the dividends were paid
subject only to certain restrictions. A corporation who would otherwise not be
eligible for the foreign tax credit may become eligible for a foreign tax
credit by use of a ULC.
Flow Through of
Losses and Expenses
Normally,
the losses of a Canadian subsidiary corporation are not deductible against the U.S.
parent’s income for U.S.
tax purposes. Since losses related to the Canadian business will flow through
to the U.S.
taxpayer, a ULC may permit a U.S.
taxpayer to write off losses from the Canadian business against income from its
U.S. business.
Similarly, if
the U.S. taxpayer
borrows money to finance the ULC, the interest paid by the U.S.
taxpayer may be deductible against its U.S.
tax liability from all sources. Alternatively, the interest paid by a ULC on
loans to finance its operations will be fully deductible for Canadian tax
purposes. If the U.S.
taxpayer lends its own funds to the ULC, the interest paid by the ULC will be
deductible for Canadian tax purposes but the interest payments will not be
considered income to the U.S.
taxpayer as this would be seen as an inter-branch transaction.
Another benefit
would be where a ULC is interposed between an ordinary Canadian business and
its U.S.
parent. The ULC could borrow from an arm’s length party and lend the money to
the subsidiary in return for principal and fully paid up shares of the
subsidiary, as the shares are not taxable for U.S.
tax purposes. The U.S.
parent and the Canadian subsidiary both receive a deduction on their respective
taxes.
Controlled Foreign
Corporation Rules
One
advantage of the ULC is with the tax treatment of accumulated earnings. Under
the IRS controlled foreign corporation rules
(“CFC”) passive income and assets (i.e., dividends,
interest, rent and royalties) of a passive foreign investment company (“PFIC”) or
a foreign personal holding company (“FPHC”) may be taxable as income and on the
sale of the shares any accumulated earnings may be treated as a deemed dividend.
A dividend is taxed as ordinary income. Since a ULC is a disregarded entity for
U.S. tax
purposes, the sale of the shares is considered a sale of the underlying assets
and subject to capital gains treatment instead. The difference in the tax rate
for ordinary income and capital gains can be substantial.
If the ULC
is capitalized with debt and preferred shares, the after-tax profits of the ULC
may be returned to the U.S.
taxpayer by the redemption of preferred shares or the repayment of debt without
incurring Canadian withholding tax.
Reduced Withholding
Taxes
Typically,
a U.S. taxpayer
is subject to a Canadian withholding tax of 15% on business profits earned by
its Canadian business. By using a ULC the income from the Canadian business will
flow through to the U.S.
taxpayer, who benefits from a reduced withholding tax on dividends of 5% under
the Canada-U.S. Tax Convention if the
U.S. taxpayer
owns at least 10% of the ULCs voting shares.
Cross Border Leases
A ULC may
also be used to avoid Canadian withholding tax on lease payments that are made
to a U.S. lessor. Normally, a non-resident is subject to Canadian
withholding tax on lease payments received by it. However, if the ULC is the lessor, the lease payments are received by a Canadian
corporation for Canadian tax purposes. The withholding tax is side-stepped. The
U.S. taxpayer
is then able to flow through the lease payments received by the ULC for U.S.
tax purposes. Interest on the loan will not be considered income for U.S.
tax purposes, but rather a gain on the U.S.
taxpayer’s Canadian assets held in the ULC. In addition, the U.S.
taxpayer may be entitled to a foreign tax credit on any Canadian taxes the ULC paid
on the rents or interest.
Taxes on Inbound
Transfers
Typically,
the IRS imposes a toll charge or excise tax
on the transfer of certain assets to a foreign corporation or partnership,
unless the U.S.
taxpayer fixes the capital gains by means of a gain recognition agreement.
Since the ULC is a disregarded entity for U.S.
tax purposes the U.S.
taxpayer may be able to transfer assets to the Canadian ULC on a tax free
basis.
In some
cases a U.S.
business intending to transfer goods and services to its subsidiary in Canada
will want to set the transfer price higher on the Canadian side to minimize its
Canadian tax liability. The U.S.
parent may be subject to double taxation if the CRA,
under the Canadian transfer pricing rules, reduces the amounts paid for goods
and services by the Canadian subsidiary corporation to its U.S.
parent and the IRS refuses to reduce its
income inclusion for U.S.
tax purposes. This can be tricky. The problem may be avoided by using a ULC. As
the payments made by the ULC to its U.S.
parent are disregarded for U.S.
tax purposes, the U.S.
taxpayer need only consider the Canadian transfer rules.
Where a
U.S. taxpayer transfers intangible property (i.e., intellectual property
rights) to an ordinary Canadian corporation, the super royalty rules kick in
and the U.S. parent is subject to a deemed annual royalty. However, the
ordinary Canadian corporation would not receive a similar deduction for the
payment of the royalties. The super royalty rules are avoided if the recipient
is a ULC, as the transfer is an inter-branch transaction.
Taxes on Outbound
Transfers
Where a
Canadian business intends to set up a permanent establishment in the U.S.,
the CRA imposes a departure tax that
includes a deemed disposition of the outbound property and reacquisition at
fair market value (“FMV”). However, when the property is eventually disposed
of, the property will be taxed by the IRS at
its initial adjusted cost base (“ACB”) rather than the FMV at departure. The
taxpayer will pay taxes on the difference twice.
A ULC can
be used to avoid this double taxation. The Canadian business must first
rollover its assets into a ULC. When the assets are transferred into the U.S.
the IRS will treat the assets as having a basis equal to its FMV at departure.
Acquiring a
Canadian Corporation
It may be
beneficial for a U.S.
business (the “Purchaser”) who intends to acquire all of an existing Canadian
business (the “Target”) to use a ULC in the transaction. On the one hand, the
Target will be taxed on a sale of shares and may therefore be eligible for the
$500,000.00 lifetime capital gains exemption or the 50% inclusion rate for
non-qualifying capital gains. On the other hand, the Purchaser will be taxed on
the acquisition of an asset.
First, the U.S.
taxpayer forms an S Corporation. Second, the Target is continued in Alberta
and converted into a ULC (“Target ULC”) before the Purchaser acquires it. Third,
the Purchaser capitalizes a ULC (“Acquisition ULC”) to acquire the shares of
the Target ULC. Finally, Acquisition ULC acquires the shares of Target ULC.
Subject to the economic substance
or business purpose tests, when capitalizing the ULC the Purchaser may step-up
or bump the basis of the underlying assets it acquires from the Target. For U.S.
tax purposes the Purchaser is merely acquiring a fully paid up asset, the value
of which is reflected in the paid up capital (“PUC”) of the ULC. In the process
of acquiring the Target the Purchaser has also stepped-up the basis of the
underlying assets for U.S.
tax purposes. The Purchaser may thereafter claim depreciation on the assets at
the new stepped-up basis and the new ACB will be used to assess capital gains on
the eventual disposition of the assets.
To remove
the need for Target ULC altogether from this transaction a U.S.
corporate taxpayer must acquire at least 80% of the Target at FMV.
Cross-Border Estate
Freezes
Where a
Canadian parent wishes to provide children living in the U.S.
with their share of an estate, typically the parent would rollover the assets
into a holding company (“Holdco”) in which the children subscribe for common
shares and the parent obtains preferred shares. While an estate freeze would
occur for Canadian tax purposes, Holdco would be considered a FPHC for U.S.
tax purposes. As a consequence the U.S.
siblings would be subject to taxable income on the passive income and assets
and a departure tax on the outbound transfer of property. This may be avoided if
Holdco were a ULC (“Holdco ULC”) and if the U.S.
siblings hold their interest in Holdco ULC through an S Corporation.
Alberta or Nova
Scotia: A Comparison of the ABULC and NSULC
Fundamentally,
the NSCA and the ABCA have evolved from different traditions, the former from
the U.K. Companies Act and the latter
from U.S. based
corporate statutes. As a result the ABCA codifies the powers of the directors
whereas the NSCA vests all the powers of the corporation in the shareholders
who, in turn, may delegate all or some of those powers to the directors. The
liability of a director is also codified in Alberta
but in Nova Scotia such liability
is based on the common law fiduciary duty. This difference has impacted the
manner in which each Act operates.
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A
Comparison of the ABULC and NSULC
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ABULC
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NSULC
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Cost of
Incorporation
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About $1,000.00 to incorporate.
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About $6,000.00 to incorporate.
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To Form a
ULC
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Registration of an ordinary corporation under the ABCA with words
expressly state that the liability of each shareholder is unlimited and joint
and several.
Any existing corporation may become an ABULC by amending its articles
of incorporation. A corporation formed outside Alberta may become an ABULC merely by continuing in Alberta and amending its articles of incorporation.
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Registration of a company under the NSCA, with unlimited liability.
A company formed outside Nova Scotia can only be continued in Nova Scotia as a company limited by shares, so a separate NSULC
must be formed and amalgamated with an existing company. The amalgamation
requires court approval.
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To
Maintain a ULC
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About $200.00 for annual returns.
Requires attorney for service of an extra-provincial corporation.
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About $2,000.00 for annual returns.
Requires a recognized agent, who must file an annual statement of
agent and pay an annual fee.
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Corporate
Restructuring
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Articles of incorporation may be amended with only shareholder
approval.
Permits short-form and long-form amalgamations. A long-form
amalgamation requires shareholder approval. A short-form amalgamation
requires only the approval of the directors.
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Memorandum of incorporation may not be amended without court approval
as well as shareholder approval.
Permits only long-form amalgamations. Amalgamations require the
approval of at least ¾ of the shareholders and also court approval.
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Corporate
Finance
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Return of Capital:
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Requires only shareholder approval so long as the liquidity and solvency
tests as met.
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Requires court approval.
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Financial Assistance/Leveraged Buyouts:
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Easier to do leveraged-buyouts because it allows both share purchase
financial assistance and the contribution of capital without the issuance of
shares.
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Difficult to do leveraged-buyouts because there is no exemption for
share purchase financial assistance.
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Declaring Dividends:
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A dividend may be declared if the Board reasonably believes that the
liquidity and solvency tests are met.
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May declare dividends without meeting the liquidity and solvency
tests.
Dividends may only be paid out of profits.
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Shares Without Par Value:
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Permits the issue of par value shares.
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Partly Paid Up Shares:
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Does not permit partly paid up shares or shares issued in exchange
for a promise to pay.
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Permits partly paid up shares or shares issued in exchange for a
promise to pay.
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Corporate Incest Rules:
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No restriction on a subsidiary holding shares in its parent for up to
30 days.
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No restriction on a subsidiary holding shares in its parent.
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Corporate
Tax Treatment
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Lower corporate tax rate.
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Amalgamation triggers a year-end for Canadian tax purposes.
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Corporate
Governance
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Unanimous Shareholder Agreements (“USAs”):
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The ABCA provides for USAs.
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The NSCA does not provide for USAs. The
relationship between the shareholders and directors is purely contractual.
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Generally:
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Corporate procedures are simpler and based on U.S. corporate model.
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Shareholders’ Meetings:
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May be held anywhere by unanimous consent of the shareholders.
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May be held anywhere.
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Directors’ Meetings:
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May be held anywhere.
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May be held anywhere.
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Special Resolutions:
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Special resolutions require approval of at least 2/3 of the
shareholders.
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Special resolution procedure is costly, cumbersome and time-consuming.
Without unanimous approval the process requires at least two shareholder’s
meetings set not less than 14 days apart. A special resolution requires
approval of at least ¾ of the shareholders.
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Shareholder
Liability
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Expressly unlimited in extent and joint and several by the articles
of incorporation. The ABULC and its shareholders may be sued
contemporaneously by a creditor, even if the ABULC has sufficient assets to
satisfy the claim.
A past shareholder may be liable for the ULC’s
debts and liabilities for up to two years after dissolution.
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No direct liability to
creditors. A shareholder’s liability for the ULC’s debts
and liabilities “kicks in” only if the company cannot meet its obligations
upon winding-up or liquidation and only to the extent of any deficiency.
A past shareholder’s
liability extends up to one year before the wind-up or for debts and
liabilities incurred after it ceased to be a shareholder, and only where the
court determines that the current shareholders cannot satisfy the deficiency.
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Directors
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Residency Requirements:
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At least ¼ of the directors must be Canadian residents.
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No residency requirements.
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Liability and Indemnity:
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Statutory liability for
corporate conduct and wages.
May indemnify for conduct
subject to statutory limits.
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Common law fiduciary duty for corporate conduct and wages.
No limit to indemnification for conduct.
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Based as it
is on a historical artifact of the U.K. Companies Act, the NSCA requires court
approval for capital reductions, amendments and amalgamations, but does not
require the solvency tests for the payment of dividends. The modern, statutory
ABCA appears to be a better option. Although amendments to the NSCA have
brought it more in-line with U.S.
corporate structure and management techniques, the NSCA is still clunky, anachronistic,
ambiguous, and out-of-step with many modern corporate trends. Moreover, the
reliance on the courts for basic corporate restructuring adds an unnecessary
degree of uncertainty and costs to the process.
The sticky
point for the ABULC is the extent of a shareholder’s unlimited liability. It is
more likely, however, that the courts will interpret a shareholder’s unlimited
liability under the ABULC very narrowly and in keeping with the general purpose
of the ULC and to differentiate an ABULC from a true partnership. In any case
the risk is managed as the U.S.
investor would always interpose a limited liability entity between it and the
ABULC.
For further
information please do not hesitate to contract the author of this
Article, Robert Omura
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